There are several structures that can be used to pass family business assets to the next generation. Family companies, family partnerships and discretionary trusts are all popular vehicles for business succession planning. In this article we highlight some of the key benefits and advantages of discretionary trusts over other structures.
What is a discretionary trust?
A trust is not a legal entity. It is a legal arrangement whereby a person (known as the “settlor”) transfers ownership of his or her assets (such as property, shares or cash) to another person (the “trustee”) who will look after those assets and use them to benefit one or more other persons (the “beneficiaries”). Details of the arrangement are usually set out in a trust deed. The trust deed will usually list one or more classes of beneficiaries (usually children, grandchildren and remoter descendants of the settlor) who may benefit from the trust.
In a discretionary trust structure, the trustees have absolute discretion as to who (from the class or classes of beneficiaries named in the trust deed) should receive the capital or income from the trust. The trustees have the legal ownership but no beneficial interest in the trust assets. The beneficiaries have no automatic right to income or capital as it arises. They merely have a hope or expectation that the trustees may exercise their discretion in their favour such that they receive appointments or use (loans) of funds and/or receive other benefits.
Advantages of discretionary trusts
The discretion given to trustees of a discretionary trust ensures that they can determine who should be the recipient of trust funds or other benefits, the quantum of any such provision and when. This allows greater flexibility in dealing with the changing needs and circumstances of the beneficiaries. Discretionary trusts are therefore an ideal vehicle for settlors who have identified a particular group of persons they would like to benefit, but are unsure which of them will need financial help in the future and in what proportions.
Protection against marital breakdown
One of the main problems in gifting assets to children directly is the risk that those assets may become available to their spouses in the unfortunate event of a marital or relationship breakdown. Uncertainty as to the enforceability of pre-nuptial agreements in Ireland accentuates this risk. By placing those assets in a discretionary trust instead of gifting them directly to children, children can receive the benefit of those assets without the assets forming part of their personal property, and therefore reducing the risk of those assets being exposed to claims from a former spouse or partner on breakdown of the relationship (although a court may make an order on a clean break as to the value of such assets or that on receipt of funds from a trust a proportion should be given to a spouse).
Avoiding oppression actions
Family business successions are typically structured so that the current value in the family business assets is locked in for the benefit of the current owners (i.e. the parents who have founded and grown the business ), while the next generation will benefit from subsequent growth in the value of those assets. At the same time, key decision making power in relation to the assets / business typically remains with the parents.
Family company structures achieve this by creating different share classes and issuing non-voting growth shares to the next generation (although in some instances voting shares are issued to the next generation, otherwise the parents’ shares may retain a disproportionately high value for CAT purposes). However, by acquiring shares in a company, the next generation automatically have access to a range of minority shareholder protections under statute and common law. A shareholder will be able to avail of these protections notwithstanding that he or she only holds non-voting shares and does not participate in day-to-day management of the business. These protections include the right to bring an action for oppression under the Companies Act, 2014, which is an extremely broad and powerful remedy for shareholders. Oppression actions can be very disruptive to a business, both in terms of the negative publicity generated and the impact they can have on day-to-day operations.
Oppression type remedies are not available to discretionary beneficiaries of a discretionary trust and the voting rights of any shares settled into a discretionary trust lie with the trustee(s) in any event.
Disgruntled beneficiaries are generally limited in their grounds of recourse to establishing that there has been a breach by the trustee of the terms of the trust, or other unlawful conduct on the part of the trustee. There is no general entitlement on a beneficiary’s part to complain that a trustee is conducting the affairs of the trust (or an underlying company) in a prejudicial or discriminatory manner.
Protection against sale of business outside the family
Placing assets in a discretionary trust avoid the problem of children selling those assets outside the family. Although restrictions on share transfers are common in family companies, typically these are structured so as to give other shareholders a so-called “pre-emption right” (or right of first refusal) on a sale, rather than an outright veto. In such cases, remaining shareholders may not have the resources or desire to buy out an exiting shareholder.
Beneficiaries of a discretionary trust do not own any trust assets unless and until the trustees make an allocation to them. This means that a creditor of the potential beneficiary will not have access to the assets in the discretionary trust to discharge a debt owed to them by the beneficiary. It also means the Official Assignee in Bankruptcy Trustee usually cannot access assets in a discretionary trust in the event of a beneficiary’s bankruptcy.
Protecting family members with illness or special needs
A discretionary trust is an ideal vehicle to provide for children or other family members who require medical care or have special needs, or who are unable to manage their own affairs. A discretionary trust can provide protection for such persons against other family members who may intend to assume control of the family assets for themselves, following the death of the settlor.
Protection against spendthrift beneficiaries
Discretionary trusts can provide for long-term protection of family assets where there are concerns as to how particular family members manage their own financial affairs. The income or capital needs of these family members can be provided for through a trust as they arise rather than gifting significant sums or assets to the individual outright, who may squander those assets and be left in a poor financial state in the long term.
Introducing new members
Although a family company structure can allow for new family members to be admitted as shareholders, it cannot match the flexibility of a discretionary trust arrangement, whereby new family members can automatically form part of a class of beneficiaries as and when they are born. In a family company structure, shares would have to be transferred or allotted to them, which can give rise to immediate capital acquisitions tax (CAT) and capital gains tax (CGT) issues.
In the past, private family trusts in Ireland enjoyed total privacy with no obligation to make any information regarding settlors, beneficiaries or assets public. However, under new regulations which came into effect at the beginning of 2019, trustees must now collate information on the beneficial owners of a trust, i.e. the settlor, trustees, protectors, beneficiaries (or classes of potential beneficiaries) and persons exercising ultimate control over the trust. This information must be kept in a beneficial ownership register, details of which will ultimately become available to the public.
However, whereas details of dividends paid to shareholders in a family company may need to be included in publicly filed annual accounts, there is no requirement to publicise details of allocations from trust funds made by trustees to beneficiaries in respect of any dividends they receive.
A key benefit of a discretionary trust is that the decisions as to which of the beneficiaries of the trust, e.g. children of the settlor, should benefit and when, is effectively “outsourced” to the independent professional trustee. This can help to avoid family disputes and allegations of favouritism.
Although minors are permitted to own shares in a company, it creates complications and is avoided in practice. Generally, shares allocated to minors are held in trust, at least until they reach the age of 18. As a trustee acts under a fiduciary position, a minor’s own interests are better protected, and not least because a professional trustee typically has professional indemnity insurance to cover claims of negligence and fidelity.
Preservation of capital value and avoiding fragmentation of ownership
Holding family business assets through a discretionary trust protects the capital value of those assets for current and future generations, rather than passing all the assets to the next generation only. In addition, in a family company structure, ownership becomes fragmented as different branches of the family pass their shares on to future generations. This is avoided in a discretionary trust, where shares remain in the hands of the trustees.
Advantages compared to family partnerships
The key advantage of a discretionary trust over a family partnership as a vehicle for holding business assets is the protection of family beneficiaries from personal liability for the debts of the business. In a general partnership, all partners have liability for the partnership’s debts. Although limited partnerships are sometimes used to avoid this scenario, these have their own limitations. In particular, in a limited partnership, so-called “limited” partners (who do not have liability for the partnership’s debts) are precluded from participating in the day-to-day management of the business (if they do participate they lose limited liability protection). This may not be appropriate where it is intended that certain members of the next generation will play a key role in the business going forward.
Disadvantages of discretionary trusts
Loss of control
Once personal assets are transferred to a trust, the trustees will control those assets. The trustees will have total discretion as to what allocations of income and capital are made out of the trust fund and to whom.
A “letter of wishes” is one way to mitigate this loss of control. This is a private letter issued by the settlor to the trustees which sets out how the settlor wishes the trustees to manage the trust fund and exercise their discretion in favour of beneficiaries. However, this letter is for guidance only and is not legally binding on the trustees. Trustees need to remain free to use their own initiative if changing circumstances of the beneficiaries require it.
As a result of the power and freedom given to trustees under a discretionary trust it is also important to think carefully about who should be appointed as trustees. The settlor must have the upmost faith (trust) in the trustees appointed. This is a personal decision, but usually trusted family members or close friends are chosen. In some circumstances it may be appropriate to appoint a professional trustee, who will be regulated and offer expertise in trust administration. In complex discretionary trusts, a combination of a professional trustee and one or two family trustees may be appropriate, especially where tax reporting under CRS and/or FATCA reporting may apply.
A settlor can also retain some control by holding the power to appoint and/or remove trustees, although this could have adverse trust or tax consequences. Alternatively and more appropriately, a settlor can appoint a close friend, family member or solicitor as a “protector”, with power to remove a trustee.
No equitable or legal interest in trust property for beneficiaries
The flexibility that is one of the major advantages of a discretionary trust can also create problems. No potential beneficiary of the trust will receive any income or capital allocation from the trust unless the trustees exercise their discretion in his or her favour. The amount of any allocation is also at the complete discretion of the trustees. A settlor may at some point have promised (following representations to the trustee(s) and/or in expectation that his wishes would be considered) a beneficiary some allocation from the trust, or the beneficiary may simply expect equal allocations to be made to all beneficiaries, but such a decision is ultimately the trustees. This can give rise to resentment, disgruntlement and potential challenges when the trustees make “unequal allocations” of income and/or capital between beneficiaries, even if they may have perfectly valid reasons for doing so. This is not specifically a downside of a discretionary trust though; it is more the result of the settlor promising or implying that things will be done over which he has no control.
Settlors need to be advised as to the potential tax implications of establishing and maintaining a discretionary trust. While these tax implications are beyond the scope of this article, they need to be carefully considered and managed in order to avoid multiple layers of taxation for the trust. The creation of a trust and the transfer of assets into that trust can give rise to potential liabilities for capital gains tax and stamp duty, and the discretionary trust itself may be subject to discretionary trust tax and / or surcharges on undistributed income at some point.
Depending on the circumstances, discretionary trusts as a standalone solution may be an ideal vehicle for passing family business assets to the next generation, particularly when combined with an underlying company. Ultimately, a combination of a discretionary trust and and un underlying investment company would provide a perfect solution to passing over wealth to the next and future generations.
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